What happens to a pooled lease when the lease terminates?

A recent decision of the Texas Supreme Court, Wagner & Brown, Ltd. v. Sheppard, has caused quite a stir in oil and gas legal circles. The court was faced with a question never before answered by a Texas appellate court, what is known as a “case of first impression.” Such cases are always interesting to oil and gas lawyers, so I thought I would weigh in on the arguments.

The facts in the case are these: Jane Sheppard owns a 1/8th mineral interest in 62.72 acres in Upshur County. She leased her 1/8th interest, and her lease – along with leases of the other 7/8ths interest in the 62.72 acres and leases of other lands- was pooled to form the W.M. Landers Gas Unit, containing 122.16 acres. Two wells were drilled on Sheppard’s tract, both producing gas.

Sheppard’s lease contains a provision requiring payment of royalties within 120 days of first sales of gas, failing which the lease would terminate. She was not paid on time, and her lease terminated.

Texas law is clear that, if there had been no pooled unit, upon termination of her lease Sheppard would become what is known as a “non-consenting co-tenant” in the two wells on her tract. She would be entitled to receive her 1/8th share of proceeds of sale of gas from the wells, less 1/8th of the costs of production and marketing. But Wagner & Brown contended that Sheppard’s tract was still bound by the pooled unit, even though her lease had expired. Under the pooling clause in Sheppard’s lease, her royalty would be calculated based on the number of acres of her tract compared to the total number of acres in the unit – in this case, 62.72/122.16, or 51.34% of the wells’ production. Wagner & Brown contended that Sheppard should receive 1/8th of 51.34% of production from the wells, less that same fraction of the cost of production and marketing. The Supreme Court agreed with Wagner & Brown, holding that “the termination of Sheppard’s lease did not terminate her participation in the unit.”

The court issued its opinion on November 21, 2008. Sheppard has filed a motion for rehearing, which is now pending. Several parties have filed amicus briefs contending that the court got it wrong. (An amicus brief is a brief filed by someone who has no financial interest in the case, but is making an argument as a “friend of the court” to point out how the court should rule.) Amicus briefs were filed by the Texas Independent Producers and Royalty Owners Association; the law firm of Cotton, Bledsoe, Tighe & Dawson, a prominent firm of oil and gas lawyers in Midland; and by Dick Watt and Laura Burney. Dick Watt is a well-known oil and gas attorney in Houston, and Laura Burney is a San Antonio lawyer who has taught oil and gas law at St. Mary’s Law School and is a frequent speaker on oil and gas subjects. All have told the court that, once a lease terminates, the pooled unit should no longer be binding on the leasehold interest. It will be interesting to see if the court is persuaded by their arguments.

Whatever the outcome of the case, it is clear that the parties could change the result, if the same situation ever arose again, by modifying the terms of the pooling clause in their lease. A pooling clause could say, for example, that “no pooled unit shall be effective as to the leased premises beyond the term of this lease.” If such language had been included in Sheppard’s lease, she would not be arguing before the Supreme Court.

But consider this possibility: what if the two wells on the W.M. Landers Gas Unit had not been drilled on Sheppard’s tract? Then, if her lease terminated, under the court’s present ruling she would still share in production from the pooled unit. But under the arguments Sheppard and her amicus curiae friends are making, she would have no further interest in the production. So, whether it is better for the pooling to remain effective as to Sheppard’s interest depends on where the wells are drilled. This presents an interesting problem for the landowner negotiating a lease, because it is impossible to predict where the lessee might drill a well. Those advocating the landowner’s interest appear to be lining up behind Sheppard’s argument, and those advocating exploration companies’ interests appear to be lining up behind Wagner & Brown’s arguments. But under different circumstances, the parties might be switching sides.

There is a second issue in Wagner & Brown v. Sheppard, not so hotly disputed, that is at least as interesting. Under established law, if a company drills a well on a tract in which there is an unleased interest, the company must account to the unleased owner for his/her share of the well’s production, less costs of operating and marketing, and less the cost of drilling and completing the well. In other words, the unleased interest owner receives nothing until the company has recovered its drilling and completion cost. But Sheppard argued that her unleased interest should be paid without reduction for the drilling and completion cost, because when the well was drilled her lease was in effect, and she was entitled to be paid as a royalty owner up until the time her lease terminated.

Again, Sheppard lost her argument. The Supreme Court held that Sheppard’s interest should be treated as if it was unleased when the well was drilled: “Sheppard had the option to continue collecting royalties free of any drilling costs, as Wagner & Brown offered to reinstate her lease on that basis. Having chosen instead (as was her right) to be a co-tenant with full benefits to the minerals she owned, it would be inequitable to allow her to escape the burdens that come with that choice.”

Note the inconsistency in the court’s reasoning. On the one hand, the court has held that, because the lease was in effect when the unit was formed and gave the lessee the right to pool Sheppard’s interest, she is bound by the pooling even though her lease later expired. On the other hand, the court says that her interest must be burdened with drilling and completion costs as if the lease was not in existence at the time the well was drilled. On both issues, the court has ruled for the lessee, and against the royalty owner.

More thoughts next week on the use of lease termination clauses in oil and gas leases.

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